The entire globe, at some point, is affected directly or indirectly by a financial crisis. We are currently living amid a global pandemic, and I thought it would be essential to talk about some of the global financial crises that have occurred in the past and the valuable lessons we can learn to protect ourselves in the future. Also, looking at the past can give us a broad perspective on how market cycles operate. In this article, I will be talking about some of the massive financial crises that have occurred in human history.
From this article, you will learn the following:
- What is a Market bubble?
- The dutch-tulip Bubble of 1637 and crowd mentality
- How are Market Bubbles Created?
- The south seas bubble of 1720 and market manipulation
- The great depression of 1929 and its impact on the general population
- The dot com bubble of 2000 and how we are blind-sighted by new technology
- The housing bubble of 2008 and corporate bailouts
- What are black swan events?
- Lessons to learn from the history of the global financial crisis
What is a market bubble?
A bubble is defined as an economic cycle characterized by the rapid escalation of asset prices followed by a contraction. In basic terms, market bubbles are a result of herd mentality and human stupidity.
When someone makes an excellent profit with an asset (Stock, bonds, real estate e.t.c.) in a short amount of time with little work, everyone is excited about how they did it, and nobody thinks that it was just dumb luck. This mentality, in turn, increases the demand for that particular asset and creates a surge in its price (Stocks, houses e.t.c) unwarranted by anything concrete, creating a market bubble. E.g., the rise in the market price of a stock may not be backed by good earning but pure speculation and emotion as people rush to buy more of it to make a quick profit. This spike in price continues until there comes the point When no more investors are willing to buy at the elevated price, a massive selloff occurs, causing the bubble to deflate.
The deflation of the bubble can also be termed as a market correction, i.e., that the price of an asset at some point comes back to its original value. There are small market bubbles that get created every once in a while, and most can be avoided quite easily with a little more work and vigilance. But massive market bubbles are too hard to see clearly, and many can suffer because of it. Lets us turn our history books and look at them individually and look at the lessons we can learn from them.
The dutch-tulip Bubble of 1637 and crowd mentality
The craze of the tulip bulb in the early 17th century is an excellent example of the stupidity in-crowd mentality. Tulips were not native to holland but instead imported as luxury goods in 1593 from turkey. As tulips were brought to a new environment, they succumbed to a disease that made the pigment in the petal break into flame-like multicolored stripes. Tulip bulbs live for more than two years (Perennial quality) and preserve their patterns. Due to the perennial quality of the flower along with the scarcity of patterns, helped to raise the perceived value of the tulip bulb. This, in turn, helped to increase the demand for the flower.
An increase in demand caused a spike in the market price. Demand also increased because merchants started to stockpile the rarest and unique patterns creating artificial scarcity. The mentality of scarcity then led to further escalation of prices. After this, people began liquidating their assets to invest in tulip bulbs, thinking that they could sell it to the next sucker at a much higher price in the future. This further added fuel to the fire and raised the price of a single bulb to astronomical heights were people were willing to sell their houses to invest in a tulip bulb. This rabid speculation developed a new method of investing called options. i.e., people could give a downpayment and promise to purchase the bulb at a later date.
In 1637 as demand for the bulbs outran the capital available, the market took a massive plunge as the bubble burst. Most, if not all, of the money that people invested in the bulb, evaporated as the price of the tulip bulbs fell.
How are Market Bubbles Created?
To visualize the above idea, imagine you want to buy onion, and currently, they are scarce and in high demand. Lets us assume that at first the price of onion is Rs.20. With a very high demand within a year, its price jumps to Rs.100 and a month later to Rs.150. This will lead to some market speculation as people may start to think that if they can buy an onion right now at Rs.150, they can sell it at Rs.200 a month later. As people rush to buy onions, the price of onions will start to skyrocket. In the next six months, a single piece of onion starts to cost Rs. 20 Lakh. People still want to buy as they think they can flip the onion to the next guy at Rs. 25 lakh a month from now. People start to run out of money, so they start putting in down payments as they cannot afford a single piece of onion. As people run out of options to generate capital, they have no choice but to sell. Market prices in a couple of days fall by one lakh after the peak of Rs. 25 Lakh. This kick starts a selling frenzy. People begin to sell the onions at even lower prices as new buyers are hard to find. People who invested 20 lakh initially would be willing to sell at a loss of 2 Lakhs or more as they don’t want further losses. This continues until the market collapses, and the price of the onion comes to somewhere around Rs 20 (It’s Original value).
This example helps to represent that markets eventually correct themselves to reach their original value and to show that the economy moves in a cycle. You always have to remember that if the economy is surging at the moment, it will not last forever, and the converse is true as well. Think of this idea like a wave. The first few buyers start to increase prices, which increases demand gradually. With an increase in demand, prices rapidly increase as it gathers more investors. Prices increase until they hit their peaks, which is sustained for a short while, after which the prices quickly fall and settle.
The south seas bubble of 1720 and market manipulation
This was probably the first real case of significant manipulation of the financial markets via pumping and dumping of stocks and insider trading. In the early 18th-century, Britain entered its age of imperial prosperity. Stock ownership remained a privilege for the aristocracy. Stocks became famous because of the ease of accessibility and that dividends paid out remained tax-free.
The parliament formed the company of the south sea as a British trade concession in 1711. It was granted a monopoly concession by the member of parliament along with a loan of 10 million pounds sterling. The company was publicly unknown at the time, so members of the parliament had bought capitalization bonds from the south seas at 55 pounds. Once the company went public, the investor exchanged each bond for 100 pounds making an instant profit of 45 pounds per bond.
The company had very inexperienced directors but managed to maintain its stock price despite all its failures, which included war with Spain, shipments of goods that were lost, and bonuses that were given to the directors, which further diluted the value of its shares.
After 1719 situation improved as Britain signed a peace treaty with Spain that enabled trade with Mexico. This provided massive prosperity to the company so much so that they offered to fund the entire British national debt of 31 million pounds.
After the treaty stock prices, they doubled, and after that, the company issued new stocks at 300-pound per share. A second issue followed at 400 pounds and quickly rose to 550 pounds within a month. Then after share prices continued to grow to 1000 pounds, after this, speculators jumped in and inflated the stock prices.
In the summer of 1720, the directors liquidated their shares and made a massive profit from the market inflation. A leak came out about what the directors had done, after which the share prices quickly collapsed.
After this, people were angry and distorted about what had happened. Specific provisions had to be made to solve the public crisis. Hence, after this, the issuance of stock certificated by the company was banned. The government confiscated the estates of company directors in an attempt to repay the investors. An exuberant proposition was placed in the parliament that wanted to put bankers in sacks, fill it with snake and throw it into the river.
The great depression of 1929 and its impact on the general population
Throughout the 1920s, the U.S. economy expanded rapidly, and the nation’s total wealth more than doubled between 1920 and 1929, a period dubbed “the Roaring Twenties.”
The New York Stock Exchange on Wall Street was the scene of reckless speculation, where everyone from millionaire tycoons to cooks and janitors poured their savings into stocks. As a result, the stock market expanded rapidly, reaching its peak in August 1929.
On October 24, 1929, as nervous investors began selling overpriced shares, the stock market crash that some had feared happened at last. A record of 12.9 million shares were traded that day, known as “Black Thursday.”
After the crash, low public spending and investments led factories and other businesses to slow down production and begin firing their workers. For those who were lucky enough to remain employed, wages fell, and buying power decreased.
Many Americans forced to buy on credit fell into debt, and the number of foreclosures and repossessions climbed steadily. As a result, millions of people lost their jobs. By early 1933, almost 13 million people were out of work, and the unemployment rate stood at an astonishing 25 percent.
The dot com bubble of 2000 and how we are blind-sighted by new technology
The dotcom bubble, also known as the internet bubble, was a rapid rise in the U.S. technology stock value fueled by investments in internet-based companies during the 1990s. People were so blind-sighted by new technology that a shoe company could increase its stock price by merely changing its name to something that sounded technological.
Investors poured money into internet startups during the 1990s in the hope that those companies would one day become profitable, and many investors and venture capitalists abandoned a cautious approach for fear of not being able to cash in on the growing use of the internet.
We, as human beings, have a disposition when it comes to new technology. At the time, Internet companies Price to earnings ratio stood close to 100:1. This was because there were too many buyers in the market who wanted to buy new and exciting technology stock. By 2001, when the bubble finally burst, many technology-related shares lost 90 to 93% of their peak value. Companies that famously survived the bubble include Amazon and eBay.
I am not a conspiracy theorist, but this story is very coincidental and interesting
When the bubble finally burst, many people involved in the pumping of the value of the stocks (This involved celebrity financial analyst) faced lawsuits and investigation by the SEC. By 2001 SEC had commenced prosecution of more than 5000 cases.
Sadly, most of their original files were destroyed along with their manhattan offices in the world trade center when it collapsed in the late afternoon of September 11, 2001. (9/11)
As a result, we may never know the extent of the fraud and market manipulation that accompanied this financial crisis.
The housing bubble of 2008 and corporate bailouts
This is the most recent example of the financial crisis that was a result of corporate greed and stupidity. The 2008 financial crisis was the most significant economic downturn since the Great Depression.
The housing market created an asset bubble in 2006. Banks bundled bad home loans with good ones and sold them as mortgage-backed securities (Like stocks). After the housing market collapsed, many banks were also on the verge of collapse when they were bailed out by the government. The Treasury at the time disbursed $441.8 billion from the Troubled Asset Relief Program (TARP).
The crisis led to the Great Recession, where housing prices dropped more than the price plunge during the Great Depression. Unemployment rose and further discouraged workers to even look for jobs. People suffered while the banks who caused the crisis distributed considerable bonuses to their employees. This showed that no matter how many times banks fuck up and destroy the economy, governments will always step in to save the day.
Let’s look at an example to understand this financial crisis a little better
Let us suppose that you are looking for ways to make a lot of money, and all of a sudden, you find a way to do that by going into real estate. Your idea is to buy a house and sell it at a higher price to the next guy. But you do not have enough money, so being the financial expert that you are, you decide to borrow money because interest rates are very low. Thus you can easily borrow money from the bank and pay it later after you sell the house.
Because the economy is going well, the bank is more than happy to lend you the money because houses are selling like crazy, and in no way, shape, or form can the bank lose money by letting you buy a home, right. Imagine thousands of people doing the same thing. The banks do not care anymore because the housing prices are rising. This is because now everyone wants to buy a house and sell it to the next sucker.
The rest of the world then starts to say,” Borrow money at lower interest rates, buy a house and make more money. It’s that easy. “. But the problem is that at some point there will be too many sellers and too few buyers. This is what is known as a financial bubble. In a bubble, there is nothing tangible that supports the rise in prices.
When the bubble finally bursts, people get stuck. Now you have houses you cannot sell and the debt you can’t pay. Because of this, they end up losing most of their money, if not all. People, on the other hand, start to default on their bank loans because they can’t sell the houses to pay the bank. Due to this, Banks begin to collapse. This is a summary of what happened with the 2008 financial crisis.
Note: When people were buying houses during the 2008 financial crisis. The loans that they were “paying” were converted into securities and sold to the general public. Hence the securities were called mortgage-backed.
What are Black Swan Events?
A black swan event is an unpredictable event that is beyond what is typically expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence that they were apparent in hindsight.
This pandemic that we see right now is one of those black swan events. It seems that this pandemic will cause catastrophic damage to our economy, and because they cannot be predicted, it can only be prepared for by building robust systems. Something that we see we don’t have, as by how the health care systems of many nations are failing amid this pandemic.
But pandemics like these may also work as a wake-up call for society. If a broken system is allowed to fail, it strengthens it against the catastrophe of future black swan events.
Lessons to learn from the history of the global financial crises
- Human Behaviour is almost always run opposite to rational and efficient behavior during a financial crisis.
- Just because on occasions markets behave irrationally does not mean we should throw away our firm foundational values of investments.
- In every economy, throughout history, the market eventually corrects itself, albeit slowly.
- Through outages, anomalies (or black swan events) arise, and markets become irrational as the economy takes a dip.
- However, the economy will slowly retain its former glory and move further, albeit slowly.
- Like any other economic crisis, this time it will not be different
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